Japanese lessons: precaution is better than cure

There is little recognition of the lessons from Japan for the global economy. But Satyajit Das says the experience of the Japanese economy provides insights into the problems being faced by economies around the world.

Japan is increasingly in the economic spotlight. After two decades of stagnation, recent initiatives to re-start the economy have fostered optimism.

Both in its decline and recent efforts, Japan's experience provides important insights into the world's current economic problems.

Getting there

Japan's post war growth was originally driven by low-cost manufacturing and an undervalued Yen. The artificially low currency emphasised growth in exports at the expense of household income and consumption. It also helped increase domestic savings rates.

On September 22, 1985, France, West Germany, Japan, the United States, and the United Kingdom agreed to the Plaza Accord, designed to devalue the Yen by intervening in currency markets. Between 1985 and 1987, the Yen appreciated by 51 per cent against the dollar moving Japan from an era of En'yasu, an inexpensive Yen, to a period of Endaka or Endaka Fukyo, an expensive Yen.

Japanese exports and economic growth fell sharply, from 4.4 per cent in 1985 to 2.9 per cent in 1986.

Desperate to restore growth and offset the stronger Yen, the Japanese authorities eased monetary policy with the Bank of Japan (BoJ) cutting interest rates from 5 per cent to 2.5 per cent between January 1986 and February 1987. The lower rates set off a debt-funded investment boom, driving real estate and stock prices higher. At the height of the "bubble" economy, the 3.41 square kilometre area of the Tokyo Imperial Palace had a theoretical value greater than all the real estate in the state of California.

Following the collapse of the bubble, policymakers have implemented a variety of economic stimulus programs. Japan's budget surplus of 2.4 per cent in 1991 has become a chronic budget deficit, increasing from 2.5 per cent in 1993 to about 8 per cent by the end of the 1990s. It has remained high during most of the 2000s. Monetary policy has been highly accommodative, including zero interest rates and multiple rounds of quantitative easing since 2001.

Despite these measures, Japan has been trapped in a period of economic stagnation, known initially as Ushinawareta Jūnen (the Lost Decade). As the economy failed to recovery and the problems extended beyond 2000, it came to be referred to as Ushinawareta Nijūnen (the Lost Two Decades or the Lost 20 Years).

Getting out

Nomura Economist Richard Koo argues that Japan is experiencing a "balance sheet recession", triggered by the collapse of financial asset prices. Financially insolvent firms are reducing debt - deleveraging - despite low interest rates. This is evidenced by a sharp fall in investment (currently around 22 per cent of GDP, down from 32 per cent in 1990) and corporations becoming net savers from net borrowers. With investment and consumption weak, government stimulus spending has become the primary driver of growth.

But Japan highlights the difficulty of engineering recovery from the effects of major deleveraging following the collapse of a debt-fuelled asset bubble. It reveals the limitations of traditional policy options - fiscal stimulus, low interest rates and debt monetisation.

Since the collapse of the Japanese debt bubble in 1989/1990, Japanese growth has been sluggish, averaging around 0.8 per cent per annum. In contrast, Japan enjoyed decades of strong economic growth - around 9.5 per cent per annum between 1955 and 1970 and around 3.8 per cent per annum between 1971 and 1990.

Nominal gross domestic product (GDP) has been largely stagnant since 1992. Japan's economy operates far below capacity, with the output gap (the difference between actual and potential GDP) around 5- 7 per cent.

Japan's public finances have deteriorated. At the time of collapse of the bubble economy, Japan's budget was in surplus and government gross debt was around 20 per cent of GDP. As the Japanese economy stagnated, weak tax revenues and higher government spending created substantial budget deficits, leading to an increase in government debt. Japanese government gross debt is now around 240 per cent of GDP. Net debt (which excludes debt held by the government itself for monetary, pension and other reasons) is about 135 per cent.

Monetary policy is ineffective with limited demand for credit. Even QE measures are subject to limits on the central bank's ability to monetise debt. The BoJ's attempts to increase inflation to reduce debt have been unsuccessful, with Japanese inflation averaging minus 0.2 per cent in the 2000s, a decline from levels of 2.5 per cent in the 1980s and 1.2 per cent in the 1990s.

Under prime minister Shinzo Abe, Japan is trying more of the same, albeit in larger amounts and with increasing desperation.

But Japan's policy alternatives are increasingly limited. A nation cannot build up unlimited public debt burdens and run continuing large budget deficits forever. The ability of the Japanese government to borrow at low rates and spend to support economic activity will become increasingly restricted.

Morbidity

Policies designed to alleviate the slowdown have also created anomalies and delayed essential structural changes, compounding fundamental problems.

The excessive manufacturing capacity and low domestic demand has exacerbated reliance on exports and a high trade surplus to balance production with demand. This ironically puts upward pressure on the Yen reducing Japan's ability to be competitive as an exporter.

Government financed infrastructure investment has allowed politicians to channel funds to favoured projects. But much of the investment is not productive. After the initial boost to activity, this infrastructure investment - bridges, roads and tunnels - requires perpetual maintenance expenditure, absorbing scarce government resources.

Low interest rates have allowed debt levels to remain high. They have also reduced income for savers, reducing consumption and encouraging additional saving for retirement.

Banks have avoided writing off loan assets, tying up capital and reduced lending to productive enterprises, especially small and medium enterprises (SMEs) which account for a large portion of economic activity and employment. Low rates have allowing weak businesses to survive in a zombie-like state, where they survive to continue to pay interest on loans which banks do not want to acknowledge can never be repaid. Firms have not sold off or restructured underproductive investments. The creative destruction necessary to restore the economy has not occurred.

Structural reforms necessary to boost growth have not been implemented.

The Japanese experience suggests that the state can provide palliative care to an economy in crisis. Its ability to restore economic health is more limited

Echoes and dissonances

There are notable similarities and differences between the collapse of Japan's bubble economy and the global financial crisis (GFC).

In both cases, low interest rates and excessive debt build-ups financed investment booms to drive recovery from recessions. Both ultimately collapsed. Both instances were characterised by overvaluation of financial assets and banking system weaknesses. The curative policies pursued in both cases - government spending to support economic activity, debt monetisation and zero interest rates- are also similar.

At the onset of the crisis, Japan had low levels of government debt, high domestic savings and an abnormal degree of home bias in investment. This allowed the government to finance its spending domestically, assisted by an accommodating central bank. Currently, around 90 per cent of Japanese government bonds are held by compliant domestic investors. The absence of market discipline allowed Japan to incur high levels of indebtedness. Many of the current problem economies have low domestic savings and are reliant on foreign capital.

Japan's problems occurred against a background of generally strong economic growth in the global economy. Strong exports and a current account surplus partially offset the lack of domestic demand, buffering the effects of the slowdown in economic activity. The global nature of the problems means that individual countries will find it more difficult to rely on the external account to support their economies.

While its aging population has increasingly compounded problems, Japanese demographics at the commencement of the crisis were helpful. Its older population had considerable wealth and low population growth meant that less new entrants had to be accommodated in the workforce during a period of slow growth, alleviating problems of rising unemployment.

Japan is an insular, homogenous society, where citizens have a strong national consciousness and stoicism shaped by the experiences of World War II and the post-war period. Citizens were accommodating of the sacrifices necessitated by the economic problems. Savers have accepted the net transfer of wealth through low interest rates to borrowers. The social structure of many troubled economies may not accommodate the measures required to manage the crisis, without significant breakdowns in social order.

These differences will greatly complicate dealing with current global economic problems.

Ignorance is bliss

There is still little recognition of the lessons from Japan for the global economy. Financial markets, in particular, seem to be oblivious to the risks of turning Japanese.

Despite its recent strong performance, the Japanese stock market is around 60 per cent below its highs at the end of 1989. The Nikkei Index fell from its peak of 38,957.44 at the end of 1989 to a low of 7,607.88 in 2003. It now trades around 10,000-15,000. Japanese real estate prices are at the same levels as 1981. Short-term interest rates have been around zero, for more than a decade. Ten-year Japanese government bonds yield around 1.00 per cent per annum.

The lesson from Japan's experience is that the only safe option to a prolonged period of stagnation is to avoid a debt-fuelled bubble and subsequent build-up of public debt in the first place. As Johann Wolfgang von Goethe knew: "Precaution is better than cure". But as John Kenneth Galbraith wryly observed: "There can be few fields of human endeavour in which history counts for so little as in the world of finance. Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present."

Satyajit Das is a former banker and author of Extreme Money and Traders Guns & Money. View his full profile here.